Central bank balance sheets swelled in size in response to the financial crisis of 2007-09. In this blog we discuss what makes them different from the balance sheets of other institutions, how they’ve been used in the past, and how they might evolve in the future as means to implement novel policies – including the revolutionary possibility that a central bank could issue its own digital currency.

Unlike private banks, profits are not likely to be an accurate measure of central bank performance, because they have much broader objectives such as financial and monetary stability.

Besides these general oddities, the accounts of any one central bank will have its own peculiar idiosyncrasies. For example, one peculiarity of the Bank of England is that its accounts separate the Issue Department from the rest of the Bank i.e. the “Banking Department” (although this is not completely unique).

This separation is purely an accounting artifice. It’s a legacy of the Bank Charter Act of 1844, the original intent of which was to ensure the Bank’s note issue was backed by gold. Although the Bank no longer adheres to a gold standard, this distinction still matters when it’s time to divvy up the Bank’s profits. While only half of the Banking Department’s profits are distributed to government (with the rest retained to cover operational expenses) 100% of all Issue Department profits go to the Treasury on the grounds that seigniorage income belongs to the sovereign.

Historical uses of the Bank of England’s balance sheet

Central banks around the world responded to the financial crisis of 2007-09 by expanding their balance sheets, as shown in the graph below. New liabilities were issued (money was created) to purchase assets from other economic agents in a process known as Quantitative Easing (QE). Growing central bank balance sheets in this way arguably prevented the recession from becoming even more severe.

Although QE often is described as unconventional monetary policy, viewed from a longer-term standpoint, the use of the Bank of England’s balance sheet to implement policy is nothing new. Here we exploit newly released weekly balance sheet data to show how the Bank has previously used its balance sheet to respond to crises. Specifically, we look at the crises of 1847, 1857 and 1866, which have been the subjects of recent Bank Underground posts and are at the heart of a current research project underway at the Bank.

The red lines represent two standard deviations from the average holdings; values between the two lines could be considered “normal”. During the crises (circled), demand for safe assets such as banknotes increased, which, under the provisions of the aforementioned Bank Charter Act of 1844, the Banking Department had to meet out of its note reserve.

In order to supply these extra notes, the Banking Department purchased assets from the private sector (known as discounting of bills) or made loans secured on those assets (known as advances). You can see in the chart below discounts and advances spiking during crises matching the fall in notes and coins in reserve observable in the chart above.

However, if the Bank of England’s note reserve wasn’t enough to meet public demand for money in the crisis, then there was a problem. The 1844 Bank Charter Act meant that the Issue Department was only allowed to print additional notes when they were backed by gold. During crisis periods, successive governments allowed the Bank to temporarily break this rule so that the Bank could meet the extra demand for notes. This “indemnity” was often enough in itself to reassure markets and end crises; only in 1857 did the Bank actually breach the provisions of the 1844 Act. This shows the mere potential to use the central bank balance sheet is a powerful instrument in itself.

The evolution of central bank balance sheets in the future

Central bank balance sheets across the world have changed dramatically over the past decade, and there are lots of reasons to believe that they will continue to evolve in novel ways in the future. These are our three favourites:

The first is that a central bank could issue digital currency (CBDC); defined as an electronic form of central bank money usable by the general public (this would not have to be a cryptocurrency). Currently, reserves are the only electronic form of central bank money that exists (with banknotes being the physical form), and only a select number of financial institutions have access to them. CBDC could potentially provide the central bank with another tool through which to conduct monetary policy, as both the quantity and/or the interest rate of CBDC could be adjusted. However, assuming the rise in CBDC isn’t matched by a fall in the issuance of banknotes, the issuance of any meaningful quantity would lead to a significant increase in liabilities for the central bank, requiring them to buy more assets. Some of these assets might be government bonds, but many central banks already hold very large quantities of these post-crisis. They may not want to hold more for fear of distorting bond markets, political worries about monetary financing, or simply because there are not enough government bonds in circulation. Although there has been a lot of discussion about how central bank digital currency could radically change payment systems – and even the financial sector as a whole – the implication for the assets on central bank balance sheets could be just as critical.

A second possible development is that central banks start to make more creative use of their equity to implement policy. Typically, central bank equity is seen just as a “loss-absorbing buffer”, instead of being actively used to implement policy. For example QE has worked – roughly speaking – by central banks creating new reserves so they can buy financial assets from the private sector. However, in theory, central banks could achieve the same ends by different bookkeeping means, issuing central bank shares in exchange for private sector assets. These shares would be different from conventional shares in a listed company as they wouldn’t give voting rights on the activities of the central bank, but apart from that, they’d be similar. An upside of using equity to buy private sector assets is that the central bank would be strengthening its capital base at a time when it’s taking on more risk.

Last but by no means least: a central bank could implement a “helicopter money drop” to stimulate the economy. There are many forms that this policy could take, but most proposals envision the money being used to monetise fiscal policy – essentially creating money for the government to either spend or distribute to people. Besides raising important questions about central bank independence, helicopter money would involve substantial change to the balance sheet of the central bank. For example, helicopter money could be implemented by the purchase of a perpetual zero-coupon government bond issued specifically for this purpose. Unlike bonds purchased in QE, this couldn’t ever be sold and would therefore provide a commitment never to unwind the policy, leading (arguably) to a larger impact on the economy. However, economists at the BIS have argued that helicopter drops would do more harm than good.

Although making predictions is hard, we’re confident that central bank balance sheets will remain important in the future, whatever comes up next.

James Barker works in the Banks’ Advanced Analytics, Research and Statistics Division along with David Bholat. Ryland Thomas works in the Bank’s Monetary Assessment and Strategy Division.

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Bank Underground is a blog for Bank of England staff to share views that challenge – or support – prevailing policy orthodoxies. The views expressed here are those of the authors, and are not necessarily those of the Bank of England, or its policy committees.

It seems much clearer to simply say that (a) the act of creating a deficit—raising the net financial wealth of the non-government sector—is fiscal policy, and (b) the act of announcing and then supporting an interest rate target with security sales (or purchases, or interest on reserves)—which has no effect on the net financial wealth of the non-government sector—is monetary policy. In the case of (a), whether the Treasury or the BOE cuts the cheques, it’s fiscal policy, and with (b), whether the Treasury or the BOE sells securities, it’s monetary policy.

In other words, fiscal policy is about managing the net financial assets of the non-government sector relative to the state of the economy, and monetary policy is about managing interest rates (and through it, to the best of its abilities, bank lending and deposit creation) relative to the state of the economy.

I think this is a much more useful taxonomy because it makes clear from the start that (1) the currency-issuing government isn’t constrained while (2) the interest rate on the national debt is a policy variable. All kinds of human suffering the past 8+ years may have been avoided if those two basic points were widely understood.

Very informative post! Your explanation behind the creation of an issue department is particularly interesting from an Indian perspective.

As you pointed out, the Reserve Bank of India too has the same separation between the issue department and the banking department. Interestingly, this separation was overlooked by the Indian government post-demonetisation.

After the Nov 8 demonetisation in India, a legislation – Specified Bank Notes (Cessation of Liabilities) Act, 2017 – was passed to provide legislative cover to the move. Section 3 of this law provided that the specified bank notes which have ceased to be legal tender shall cease to be liabilities of the “Reserve Bank under section 34” the Reserve Bank of India Act, 1934. However, section 34 only talked about “Liabilities of the Issue Department”. Effectively, the separation of Issue Department from the rest of RBI did not really matter when it ought to have mattered the most!

Given that the Bank of England can never run out of pounds sterling (as it is the issuer) and would not refuse a request for payment from a Government account held at the Bank, provided the request was done through the appropriate channels and was in line with the relevant regulations, it seems to me that overt monetary financing is a viable option.

You also said: “…a perpetual zero-coupon government bond issued specifically for this purpose. Unlike bonds purchased in QE, this couldn’t ever be sold and would therefore provide a commitment never to unwind the policy”

I don’t want to sound like a crank, but…

It could easily be sold to the Treasury, should the authorities (CB & Treasury) decide to unwind the policy. So there’s no commitment never to unwind, other than saying that “we will never unwind this — trust us”. Thus, it wouldn’t differ that much from the Treasury selling a perpetual (or even a defined-maturity) NON-zero-coupon bond to the CB, and the CB promising to never sell it to the public (and if not perpetual, then to roll it over indefinitely). The only difference would be that in the latter case the CB wouldn’t need to consult the Treasury in order to be able to break its promise (although I’m not sure if the CB can act alone in the UK in this kind of situation — Treasury has more power in the UK, right?).

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Bank Underground is a blog for Bank of England staff to share views that challenge – or support – prevailing policy orthodoxies. The views expressed here are those of the authors, and are not necessarily those of the Bank of England or its policy committees.

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